401(k) Plans: The Current State
On Monday, Jim McCool talked about the history and evolution of the 401(k) plan. Today, Schwab’s Executive Vice President of Institutional Services turns his attention to the current system and how it can be improved.
Q. How do we improve the current system?
McCool: We need to rethink the 401(k) plan and find ways to help set workers on a path to increase their retirement savings so that they can be more adequately prepared for that phase of their life. This is increasingly important as people are living longer and their savings need to extend further as a result. And we know that most Americans do not feel adequately prepared to meet their financial requirements for retirement. We need to consider this need and focus on reducing the complexity of 401(k) saving and investing. To do this, Schwab’s new alternative addresses the two critical drivers that we believe can help generate positive retirement outcomes: lowering cost and increasing the use of independent, personalized advice.
Q. Tell me about costs.
We need to find ways to reduce fund operating expenses workers pay with respect to their 401(k) investment options. Research shows that approximately 85% of the $2.8 trillion in 401(k) assets is in what we call “actively managed asset strategies,” such as large cap mutual funds.1 These actively managed funds can offer advantages to people saving for their future, but they also tend to be more expensive, as they require a fund manager to make individual decisions about stocks and bonds to buy or sell. The goal of these funds is to deliver higher returns than their market benchmark. But it is often difficult to consistently beat the benchmark, especially over long periods of time.
That’s why we think long-term investors, like people saving through 401(k) plans, may have a better opportunity to accumulate more savings for retirement by using “passively managed asset strategies” or “index investing,” which uses mutual funds or exchange-traded funds (ETFs) that follow a specific index. The goal of index funds is to match the performance of an index, rather than trying to beat the market. Some popular indexes include the S&P 500 and the Russell 2000. Simply put, index investing aims to minimize risk and take some of the guesswork out of investing, while charging low fund operating expenses.
Generally, index funds are less expensive to manage compared to actively managed funds, as the index fund managers buy and sell stocks to track the performance of the index, eliminating much of the costs associated with research and the more frequent buying and selling that can occur in an actively managed fund.
Through such low-cost index investments, fund operating expenses could be cut significantly. For the average worker in a 401(k) plan, that can mean nearly $115,000 more at retirement.2 And that’s just for one worker in a 401(k) plan. Imagine what it would mean across nearly 50 million workers currently saving in a 401(k). By 2050 that could mean $10 trillion saved by retirees.
Q. What role does advice play?
McCool: The impact of advice plays a very important role. By advice I mean guidance offered to people by independent financial professionals. This can be done over the phone or online, but the point is to make sure people have a resource to get their investing questions answered and get the help they seek.
At Schwab, we have found when someone used independent, personalized professional 401(k) advice, they often made more informed decisions, saved more, were better allocated across asset classes and often stayed with the market in good times and bad, which can be a huge benefit.3 And another recent study reports that for a worker who starts saving at age 45, getting professional advice could mean 70 percent more savings at retirement.4 But currently, our data shows that only about 10% of 401(k) savers use advice services.3 It’s clear based on our experience that we need to look for ways to get more people to use advice if we are going to help them reach their retirement goals.
On Friday, Jim McCool will talk about how Schwab is addressing the retirement savings challenges American workers face. Until then, take a look at your most recent 401(k) statement, do you understand how/where your money is allocated? When was the last time you looked at your 401(k) statement and made sure your investments are still in line with your current situation or that your retirement goals haven’t changed? Share your comments and questions below.
1 Winning in the Defined Contribution Market of 2015: New Realities Reshape the Competitive Landscape, McKinsey & Company, September 2010.
2 Hypothetical assumptions for illustrative purposes only supporting an additional ~$115,000 to a 401(k) participant’s retirement savings: Annual market growth, 7.50%; initial contribution rate (year 1), 5.00%; increase in contribution rate (each year for years 2-6), 1.00%; ongoing contribution rate (each year for years 6-30), 10.00%; employer match, $.50 per $1 for the first 6% of income contributed; beginning salary, $50,000; yearly salary increase, 3.0%; starting age, 25; age at first year of distributions, 55; percent of last salary distributed annually, 50.0%. Approximate difference of $115,000 represents the additional account balance resulting from an investment allocation comprised of index mutual funds with a total weighted average operating expense ratio (OER) of 20 basis points versus an investment allocation comprised of actively managed mutual funds with a higher total weighted average OER of 86 basis points. The 86 basis point assumption is based on Cerulli analysis of mid-sized 401(k) plans. Assumptions do not factor in the potential impact of professional, independent advice services, nor any fees that may be associated with these services or other fees that may be charged to a participant account. Results not guaranteed.
3 Advice data based on 401(k) plans serviced by Schwab Retirement Plan Services, Inc. that offer independent advice to their participants through GuidedChoice Asset Management, Inc.
4 Financial Engines/Aon Hewitt Study: “Help in Defined Contribution Plans: 2006 Through 2010.” September 2011. According to the study, participants in 401(k)s that received professional “Help”, on average, experienced returns nearly 3% (292 basis points) per year higher than participants that did not receive such “Help”. For example, suppose that two participants, one using “Help” and one not using “Help”, each invest $10,000 at age 45. Using the return difference of 292 basis points, the “Help” Participant could have 70% more wealth at age 65 ($71,400) than the “Non-Help” Participant ($42,100). For purposes of the study, “Help” is defined as professional investment help, under the study meaning target date funds, managed accounts and online advice, including fee-based and non-fee-based advice. All returns reported in this study are net of fees, including fund-specific management and expense fees, and managed account fees where applicable. Results not guaranteed.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-724-7526. Please read the prospectus carefully before investing.
Remember that cost is only one consideration when making an investment decision. Investment returns and principal value of index mutual funds will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Index mutual funds are not without risk and an investor may give up the opportunity to outperform the market by not being in an actively managed fund. All index mutual funds are subject to management fees and expenses.
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